Another story of leveraging gone wrong…..

Significant and inappropriate leverage violates one of the key objectives of portfolio construction planning and management for individuals with financial demands on a portfolio – this objective is to minimise the risks to the ability of assets to meet these needs over time. Adding substantial leverage to a portfolio that is needed to meet financial needs increases the uncertainty of income and capital security.

From the Financial Post, a “Victim of bad advice struggles to pay off investment disaster” should be a lesson to all those with advisors/advisers who recommend leverage as a significant part of their investment strategy.

Quite frankly most retail leveraged strategies should be kicked into touch by regulators, but like transactions’ remuneration and limited suitability standards, it is a case of the past and its interests dictating the future.   Sometimes human beings are capable of greatness, at other times embarrassingly unabashed ignorance, cruelty and self interest.  

This (leverage) is no better than selling cigarettes to toddlers, and if you wanted to point the finger at anything that epitomises the attitude of product distribution to the investor, look no further than leverage.  

Borrowing to invest for the retail small investor has to clear a very high hurdle: high mutual fund costs/or other management costs and loan costs, not to mention the risks of under performance, interest rate risks and the impact of short term market volatility and longer term bear markets.    The impact of costs alone, on many products, could beat the historical risk premium over bonds in Canadian markets over many a time frame, yet leverage remains an important part of the salesperson’s armoury.   From 1963 to 2012 the real return on equities above bonds has been 1%, according to the Credit Suisse Global Investment Returns Yearbook 2013, and 3.4% since 1900.

I think most people forget that equity returns are already leveraged given that most corporations already borrow significant sums and that a corporation’s revenue is from sources that are likewise leveraged.   An unmanaged leveraged position is a doubling up on such embedded economic risks. 

Significant leverage, at best, is first and foremost a professional’s game, yet most professionals would not dream of holding the type of high cost leveraged positions we see amongst many smaller investors, let alone hold these positions throughout a full market cycle.

I am not against leveraged strategies per se, but these strategies need to be carefully incorporated and managed within appropriately structured portfolios.   They should also not be a standard recommendation and should exist only on the very high risk spectrum of portfolio options.  But even here, leverage should be with capital that can afford to be lost, with capital that is not needed to meet an individual’s liabilities given conservative risk/return assumptions.   And more, if provided by an advisor it requires a strategy, especially if tied to active investment allocations.  Leveraged strategies are complex, sophisticated and require a specific expertise to manage.

Leverage is a marginal strategy (best suited to sophisticated investors with very high risk preferences and capital to burn) preferably focussed on key turning points in market and security life cycles.  Given the difficulties of market timing, even those employing leverage at appropriate valuations with disciplined strategies can be exposed to adverse market movements.  

Yes, there is an academic argument for leverage – higher risk/higher return assets should be priced to outperform the costs of capital over time and that leverage would capture this pricing differential.   But this is often an “academic” exercise that ignores many of the costs and the inefficiencies of advice and the market place and many other risks.

Yes, we also use leverage to buy homes, but here again the arguments are not necessarily supportive of risky asset investment. With a home purchase you are more often than not swapping rental costs for financing and other homeowner costs.  A residence whose value has fallen below the value of the loan has utility, but the high cost often poorly structured investment portfolios that have fallen below the value of the loan have no utility and are a financial burden.  

Significant and inappropriate leverage also violates one of the key objectives of portfolio construction planning and management for individuals with financial demands on a portfolio – this is to minimise the risks to the ability of assets to meet these needs over time. Adding substantial leverage to a portfolio that is needed to meet financial needs increases the uncertainty of income and capital security.  

Can we ban leverage from the universe of potential portfolio options?  No of course not!    There will be individuals who genuinely want an aggressive high risk investment strategy and those who are genuinely capable of delivering it, irrespective of the risks and outcomes, but this is not the situation in the Canadian retail financial services market place where leverage appears to be more a rite of passage.  

The ordinary sales person (advisor so named) does not possess anywhere near the expertise needed to deal in leverage and the ordinary investor likewise.  I fail to see exactly how leverage, in the shape and form we see it delivered in our retail market place, serves any interest other than the seller of leverage. 

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